Exclusion ratio

The exclusion ratio is used for taxing non-qualified immediate annuity payments or non–qualified deferred annuities distributed as instalments. It is a part of the sum that is not reported as ordinary income.

It is designed to return the owner–purchase annuity investment in tax-free amounts over the given period and tax the balance of the sum received.

If a person purchases it for $100K at age 65, the insurance firm can estimate the life expectancy to be 20 years and promise to give $565 a month for the rest of the life, where they spread the total over 20 years and then get approx. monthly sum, which is $417 a month) but it is higher than the calculated spread because the firm returns the sum portion derived after tax plus interest.

The expected return and investment in the contract are the terms used to calculate the portion of each annuity reimbursement excluded from earnings as tax-free of principal.

The exclusion ratio is considered part of the original investment instead of ordinary income earned on the money. The part of each annuity expense eliminated from the earnings reduces the unrecovered investment.

Each disbursement is the non-taxable return of cost and part of the taxable revenue. Any additional interest associated with it is reported as the wage of the financial year, and it should be determined as a part of the contract. 

At the same time, the balance of the guaranteed annuity payment is includable in gross proceeds for the given year received.

It is related to certain capital guarantee contracts and works as the ratio where the total investment exceeds the expected return. If the initial sum is greater than or equals the value of the likely returns, the full amount of each disbursement is received tax-free. Future payments are taxable if the owner–purchase is still alive at life expectancy.